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Capital-Markets Activities Manual
Source: Federal Reserve System
(The complete Activities
Manual (pdf format) can be downloaded from the Federal Reserve's web
Senior management of financial institutions
should establish ethical standards and codes of conduct governing the
activities of their employees to protect the institution's integrity and
standing in the market. The orderly operation of financial markets depends
greatly on an overall level of trust among all market participants. Traders
and marketing and support staff must conduct themselves at all times with
unquestionable integrity to protect the institution's reputation with
customers and market participants.
CODES OF CONDUCT AND ETHICAL STANDARDS
To ensure that employees understand all ethical
and legal implications of trading activities, institutions should have
comprehensive rules of conduct and ethical standards for capital-markets
and trading activities-especially in areas where the complexity, speed,
competitive environment, and volume of activity could create the potential
for abuse and misunderstandings. At a minimum, policies and standards
should address potential conflicts of interest, confidentiality and the
use of insider information, and customer sales practices. Ethical standards
and codes of conduct in these areas should conform with applicable laws,
industry conventions, and other bank policies. They should also provide
proper oversight mechanisms for monitoring staff compliance and dealing
with violations and customer complaints. Internal controls, including
the role of internal and external audits, should be appropriate to ensure
adherence to corporate ethical standards of conduct. Policies and procedures
should provide ongoing training for staff, as well as periodic review,
revision, and approval of ethical standards and codes of conduct to ensure
that they incorporate new products, business initiatives, and market developments.
Conflicts of Interest
Institutions should ensure that capital-markets personnel do not allow
self-interest to influence or give the appearance of influencing any activity
conducted on behalf of the institution. Safeguards should include specific
restrictions on trading for the employee's personal account and on the
acceptance of gratuities and entertainment. When developing compensation
programs, institutions should recognize and guard against any potential
conflicts that may arise between compensation structures and the institution's
code of ethics and standards of conduct.
Fee-based activities, securitization, underwriting, and secondary-market
trading activities in a number of traditional bank assets may create the
potential for conflicts of interests if there is no clear segregation
of duties and responsibilities. Conflicts of interest may arise when access
to inside information gives an institution an unfair advantage over other
market participants. Accordingly, policies should ensure that employees
conduct themselves consistent with legal and regulatory restrictions on
the use of inside information.
Confidentiality and Insider Information
The maintenance of confidentiality and customer anonymity is critical
for the operation of an efficient trading environment. No client information
should be divulged outside the institution without the client's authorization
unless required by law or by regulatory authorities acting in their official
capacities. Managers are responsible for ensuring that their staffs are
aware of what constitutes confidential information, and that they know
how to deal appropriately with situations that require customer anonymity.
Many institutions have established appropriate policies (so-called ''Chinese
walls'') that separate those areas of the institution that routinely have
access to confidential or insider information from those areas that are
legally restricted from having access to the information. To prevent the
misuse of confidential information, employees in sensitive areas should
be physically segregated from employees in public areas.
It is a sound business practice for managers to establish policies and
procedures governing standards for dealing with counterparties. These
guidelines and policies preserve the institution's reputation in the marketplace
by avoiding situations that create unjustified expectations on the part
of a counterparty or client. When determining the responsibilities of
sales and marketing staff, management should take into account the sophistication
of the counterparty, the nature of the relationship, and the type of transaction
being contemplated or executed. In addition, certain regulated entities
and markets may have specific legal or regulatory requirements governing
sales and marketing practices, which marketers and sales personnel must
be aware of.
Financial institutions should take steps to ascertain the character and
financial sophistication of their counterparties. An appropriate level
of due diligence should be performed on all counterparties with which
the institution deals. Financial institutions should also determine that
their counterparties have the legal authority to enter into, and will
be legally bound by the terms of, the transaction.
When an advisory relationship does not exist between a financial institution
and its counterparty, the transaction is assumed to be conducted at ''arms-length''
and the counterparty is generally considered to be wholly responsible
for the transactions it chooses to enter. At times, clients may not wish
to make independent investment or hedging decisions and instead may wish
to rely on a financial institution's recommendations and investment advice.
Similarly, clients may give a financial institution the discretionary
authority to trade on their behalf. Financial institutions providing investment
advice to clients, or using discretionary authority to trade on a client's
behalf, should formalize and set forth the boundaries of these relationships
with their clients. Formal advisory relationships may entail significantly
different legal and business obligations between an institution and its
customers than less formal agency relationships. The authority, rights,
and responsibilities of both parties should be documented in a written
Marketing personnel should receive proper guidance and training on how
to delineate and maintain appropriate client relationships. This includes
guidance to sales and trading personnel regarding the avoidance of the
implication of an advisory relationship when none is intended.
While procedures may vary depending on the type and sophistication of
a counterparty, for its own protection, a financial institution should
take steps to ensure that its counterparties understand the nature and
risks inherent in agreed-upon transactions. When a counterparty is unsophisticated,
either generally or with respect to a particular type of transaction,
the financial institution should take additional steps to adequately disclose
the attendant risks of specific types of transactions. Furthermore, a
financial institution that recommends specific transactions to an unsophisticated
counterparty should ensure that it has adequate information on which to
base its recommendation-and that the recommendation is consistent with
the needs of the counterparty as known to the financial institution. The
institution also should ensure that its recommendations are consistent
with any restrictions imposed by a counterparty's management or board
of directors on the types or amounts of transactions it may enter into.
Institutions should establish policies governing the content of sales
materials provided to their customers. Typically, these policies call
for sales materials that accurately describe the terms of the proposed
transaction and provide a fair representation of the risks involved. Policies
may also identify the types of analysis to be provided to the customer
and often specify that analyses include stress tests of the proposed instrument
or transaction over a sufficiently broad range of possible outcomes to
adequately assess the risk. Some institutions use standardized disclosure
statements and analyses to inform customers of the risks involved and
suggest that the customer independently obtain advice about the tax, accounting,
legal, and other aspects of a proposed transaction.
Institutions should also ensure that procedures and mechanisms to document
analyses of transactions and disclosures to clients are adequate and that
internal controls ensure ongoing adherence to disclosure and customer-appropriateness
policies and procedures. Management should clearly communicate to capital-markets
and all other relevant personnel any specific standards that the institution
has established for sales materials.
Many customers request periodic valuations of their positions. Institutions
that provide periodic valuations of customers' holdings should have internal
policies and procedures governing the manner in which such quotations
are derived and transmitted to the customer, including the nature and
form of disclosure and any disclaimers. Price quotes can be either indicative,
meant to give a general level of market prices for a transaction, or firm,
which represent prices at which the institution is willing to execute
a transaction. When providing a quote to a counterparty, institutions
should be careful that the counterparty does not confuse indicative quotes
for firm prices. Firms receiving dealer quotes should be aware that these
values may not be the same as those used by the dealer for its internal
purposes and may not represent other ''market'' or model-based valuations.
When securities trading activities are conducted in a registered broker-dealer
that is a member of the National Association of Securities Dealers (NASD),
the broker-dealer will have obligations to its customers under the NASD's
''business conduct rule'' and ''suitability rule.'' The banking agencies
have adopted identical rules governing the sales of government securities
in financial institutions. The business-conduct rule requires an NASD
member to ''observe high standards of commercial honor, and just and equitable
principles of trade'' in the conduct of its business. The suitability
rule requires that, in recommending a transaction to a customer, an NASD
member must have ''reasonable grounds for believing that the recommendation
is suitable for the customer upon the basis of facts, if any, disclosed
by the customers as to the customer's other securities holdings and as
to the customer's financial situation and needs.''
The suitability rule further provides that, for customers who are not
institutional customers, an NASD member must make reasonable efforts to
obtain information concerning the customer's financial and tax status
and investment objectives before executing a transaction recommended to
the customer. For institutional customers, an NASD interpretation of its
suitability rule requires that a member determine (1) the institutional
customer's capability for evaluating investment risk generally and the
risk of the particular instruments offered and (2) whether the customer
is exercising independent judgment in making investment decisions. The
NASD interpretation cites factors relevant to determining these two requirements.
Management should monitor any pattern of
complaints concerning trading, capital-markets, and sales personnel that
originate from outside the institution, such as from customers, other
trading institutions, or intermediaries. Patterns of broker usage should
be monitored to alert management to unusual concentrations. Broker entertainment
of traders should be fully documented, reviewed, and approved by management.
In addition, excessive entertainment of brokers by traders should be prohibited.
Management should also be well acquainted
with the institution's trading activities and corresponding reports so
that, upon regular review, they can determine unusual patterns or concentrations
of trading activity or transactions with a customer that are not consistent
with the customer's usual activities. Management should clearly and regularly
communicate all prohibited practices to capital-markets and all other
Personnel affirmations and disclosures are
valuable tools for ensuring compliance with an institution's code of conduct
and ethical standards. Procedures for obtaining appropriate affirmations
and disclosures where and when required, as well as the development of
forms on which these statements are made, are particularly important.
At a minimum, employees should be asked to acknowledge annually that they
have read and understood the institution's ethics and code of conduct
standards. Some companies also require that this annual affirmation contain
a covenant that employees will report any noted violations. Several major
financial institutions have adopted additional disclosure procedures to
enforce the personal financial responsibilities set out in their codes.
They require officers to file with the compliance manager an annual statement
dealing with family financial matters or, in some cases, a statement of
indebtedness. Finally, many institutions require traders to conduct their
personal trading through a designated account at the institution. Adequate
internal controls including review by internal audit and, when appropriate,
external audit are critical for ensuring compliance with an institution's
1. To determine if the institution has adequate
codes of conduct and ethical standards specific to its capital-markets
and trading activities, that their scope is comprehensive, and that they
are periodically updated.
2. To review and ensure the adequacy of
the institution's policies, procedures, and internal-control mechanisms
used to avoid potential conflicts of interest, prevent breeches in customer
confidentiality, and ensure ethical sales practices across the institution's
trading activities. To determine if the institution has established appropriate
and effective firewall policies where needed.
3. To determine that management has adequate
policing mechanisms and internal controls to monitor compliance with the
code of ethics and that procedures for reporting and dealing with violations
are adequate. To determine if the supervision of staff is adequate for
the level of business conducted.
4. To recommend corrective actions when
policies, procedures, practices, or internal controls are found to be
deficient or when violations of laws, rulings, or regulations have been
These procedures represent a list of processes
and activities that may be reviewed during a full-scope examination. The
examiner-in-charge will establish the general scope of the examination
and work with the examination staff to tailor specific areas for review
as circumstances warrant. As part of this process, the examiner reviewing
a function or product will analyze and evaluate internal-audit comments
and previous examination work-papers to assist in designing the scope
of the examination. In addition, after a general review of a particular
area to be examined, the examiner should use these procedures, to the
extent they are applicable, for further guidance. Ultimately, it is the
seasoned judgment of the examiner and the examiner-in-charge as to which
procedures are warranted in examining any particular activity.
1. Obtain copies of the institution's written
code of conduct and ethics and any related policies and guidance. Determine
if there are codes specific to all relevant trading and marketing activities.
2. Obtain any procedures used to guide staff
in developing new accounts or preparing sales presentations and documents.
3. Evaluate the various codes and policies
as to their adequacy and scope. Are prohibited practices clearly identified?
These may include but are not limited to the following:
a. altering clients' orders without their permission
b. using the names of others when submitting bids
c. compensating clients for losses on trades
d. submitting false price information to public information services
e. churning managed client accounts
f. altering official books and records without legitimate business purposes
g. trading in instruments prohibited by regulatory authorities
4. Are standards for the content of sales
presentations and the offering transaction documents clearly identified?
Do these standards address an appropriate range of transactions, customers,
and customer relationships?
5. Review the institutions's firewall policies
segregating its trading and advisory activities from those areas which
have access to material non-public or ''insider information.'' Are the
areas physically separated? Are employees aware of the requirements of
the law restricting the use of such information, specifically section
10(b) of the Securities Exchange Act of 1934 and SEC Rule 10(b)5?
6. Identify the officer within the institution
who is designated as compliance manager. Are trading personnel required
to confirm in writing their acknowledgment of the various codes and to
report violations? Are they required to file annual statements of indebtedness
and outside affiliations? Check to see that adherence to these reporting
requirements is being monitored by the compliance manager.
7. Determine how compliance with sales-practice
policies is monitored by the institution. Are personnel outside the trading
area reviewing sales documents and disclosures for compliance with policies?
Review and evaluate the findings of internal and external audits conducted
in this area.
8. Conduct limited transaction testing of
sales documentation to review compliance with financial-institution policies
and sound practices.
9. Determine if there is a general policy
concerning violations of the code. Is there a specific procedure for reporting
violations to senior management and the general auditor? Does it detail
grounds for disciplinary action?
10. Recommend corrective action when policies,
procedures, practices, or internal controls are found to be deficient
or when violations of laws, rulings, or regulations have been noted.
Internal Control Questionnaire
1. Does the institution have a written code
of conduct or ethics? Are there specific codes for capital-markets staff?
a. Is there a statement as to the code's intention to conform with U.S.
laws or laws of other countries where the institution has operations?
b. Does this code cover the whole institution, including subsidiaries?
If not, are there codes that apply to those particular areas?
c. Does the code address specific activities which are unique to this
particular institution? Do other areas of the institution with a higher
potential for conflicts of interest have more explicit policies?
d. Do the codes address the following issues:
• Employee relationships with present or prospective customers
and suppliers? Has the institution conducted appropriate inquiry for customer
integrity? Does the institution's code properly address the following
employee-customer or supplier relationship issues?
- safeguarding confidential information
- acceptance of gifts
- outside activities
-kickbacks, bribes, and other remunerations
- integrity of accounting records
- candor in dealings with auditors, examiners, and legal counsel
- appropriate background check and assessment of the credit quality and
financial sophistication of new customers
- appropriate sales practices
• Internal employee relationships between specific areas of the
- Do policies exist covering the relationship on sharing information between
trading and other areas of the bank?
- Is the confidentiality of account relationships addressed?
• Personal employee activities outside
the corporation? Does the institution-
- periodically check whether employees maintain sound personal financial
conduct and avoid excessive debts or risks?
- monitor employee business interaction with other staff members, family,
or organizations in which an employee has a financial interest?
- prohibit employee use of confidential information for personal gain?
provide for adequate control over trading for personal accounts?
- require periodic disclosure and approval of outside directorships and
• Regarding personal and corporate
political activities, is the illegality of corporate political activities
(for example, contributions of goods, services, or other support) addressed?
• The necessity to avoid what might only appear to be a possible
conflict of interest?
2. Does management have the necessary mechanism
in place to monitor compliance with the code of ethics?
a. Are officers and staff members required to sign an acknowledgment form
that verifies they have indeed seen and read the code of conduct and ethics?
• Is there a periodic program to
make staff aware of and acknowledge the importance of adhering to the
• Are officers required to disclose their borrowing arrangements
with other financial institutions to identify a potential conflict of
b. What departments and which officers are responsible for monitoring
compliance with the code of conduct and ethics and related policies? What
mechanisms do they employ and are they adequate?
c. How is information in the code relayed to staff?
• Have there been any breaches of the code? If so, what was the
situation and how was it resolved?
• Do bank personnel avail themselves of the resources outlined
in the code when there is a question regarding a potential conflict of
interest? If not, why?
• Are all employees aware of the existence of the code? If not,
• Does the bank's management generally believe that all potential
conflicts of interest have been anticipated and are adequately covered
in the code?
• Are internal auditors involved in monitoring the code of ethics?
• Does the organization's culture encourage officers and employees
to follow the standards established by the code?
3. Are there resources for an employee to
obtain an opinion on the legitimacy of a particular circumstance outlined
in the code of conduct and ethics?
a. Does the code emphasize the need for
employees to report questionable activities even when the issues are not
their particular responsibility? Are the proper channels of action outlined
for these types of cases?
b. Does the code outline the penalties or
repercussions such as the following for breach of the code of conduct
• potential to lose one's job?
• potential for civil or legal action?
• eventual damage to the corporation's reputation?
4. Is the code of ethics updated frequently
to encompass new activities?
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